On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this second blog discussing offering communications including new rules related to demo days and generic testing the waters. The first blog in the series discussed the new integration rules (see HERE).
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering from the Act’s registration requirements. Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest. Rule 506 is “safe harbor” promulgated under Section 4(a)(2). If all the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with.
Effective September 2013, in accordance with the JOBS Act, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rule 506 by bifurcating the rule into two separate offering exemptions. The historical Rule 506 was renumbered to Rule 506(b) and new rule 506(c) was enacted. Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors – provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, must be provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.
Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and the company has an additional burden of verifying such accredited status. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Accordingly, in the Rule 506 context, determining whether solicitation or advertising has been utilized is extremely important.
Other private offerings also allow for solicitation and advertising. In particular, Regulation A, Regulation Crowdfunding, Rule 147 and 147A, and Rule 504 all allow for solicitation and advertising. For more information on Rule 504, Rule 147 and 147A, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. Part 1 of this blog series talked about issues with integration, including between offerings that allow and don’t allow solicitation, but equally important is determining what constitutes solicitation in the first place.
Prior to the JOBS Act, general solicitation and advertising was prohibited in most exempt offerings and “testing the waters” was not yet a mainstream term of art in the capital markets. Following the JOBS Act creation of Rule 506(c), Regulation Crowdfunding and the new Regulation A/A+ structure, offering solicitation and pre-offering testing the waters became the norm. Recognizing the benefits of additional offering communications, and testing the waters prior to launching an offering, the SEC has included expanded offering communications and testing the waters provision in its modernized exempt offering rules.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Offering Communications; Expansion of Test-the-Waters Communications; Addition of “Demo Days”
The Securities Act defines the term “offer” very broadly and includes any publication of information or communication in advance of a financing that would have the effect of arousing interest in the securities being offered. Likewise, general solicitation and advertising have been interpreted very broadly. Although Rule 502(c) lists some examples, the SEC has expanded upon those examples over the years, including information posted on an unrestricted website as a general solicitation.
Rule 502(c) lists the following examples of solicitation or advertising:
- Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising; provided, however,that publication by a company of a notice in accordance with Rule 135c or filing with the SEC of a Form D shall not be deemed to constitute general solicitation or general advertising; and provided further that, if the requirements of Rule 135e are satisfied, providing any journalist with access to press conferences held outside of the U.S., to meetings with companies or selling security holder representatives conducted outside of the U.S., or to written press-related materials released outside the U.S., at or in which a present or proposed offering of securities is discussed, will not be deemed to constitute general solicitation or general advertising.
Generally, testing the waters through contacting potential investors in advance of an exempt offering to gauge interest in the future offering, could be deemed solicitation. In 2015 the SEC issued several C&DI to address when communications would be deemed a solicitation or advertisement, including factual business communications in advance of an offering and demo days or venture fairs.
At that time, the SEC indicated that participation in a demo day or venture fair does not automatically constitute general solicitation or advertising under Regulation D. If a company’s presentation does not involve the offer of securities at all, no solicitation is involved. If the attendees of the event are limited to persons with whom either the company or the event organizer have a pre-existing, substantive relationship, or have been contacted through a pre-screened group of accredited, sophisticated investors (such as an angel group), it will not be deemed a general solicitation. However, if invitations to the event are sent out via general solicitation to individuals and groups with no established relationship and no pre-screening as to accreditation, any presentation involving the offer of securities would be deemed to involve a general solicitation under Regulation D. For more on a pre-existing substantive relationship, see HERE.
The amended rules specifically exempt “demo days” from the definition of general solicitation and advertising for all offerings; allow companies to use generic solicitations of interest communications prior to determining which exempt offering they will rely upon or pursue; and add test-the-waters provisions to Regulation Crowdfunding.
Demo Days; New Rule 148
“Demo days” and similar events are generally organized by a group or entity that invites issuers to present their businesses to potential investors, with the aim of securing an investment.
New Rule 148 provides that certain demo day communications will not be deemed to be a general solicitation or advertising. Specifically, a company will not be deemed to have engaged in general solicitation if the communications are made in connection with a seminar or meeting sponsored by a college, university, or other institution of higher education, a local government, a state government, instrumentalities of state and local governments, a nonprofit organization, or an angel investor group, incubator, or accelerator and in which more than one company participates. Rule 148 excludes broker-dealers and investment advisors from the scope of the exemption.
Rule 148 requires that “angel investor groups” maintain defined processes and procedures for making investment decisions, though the rule does not require that the processes be memorialized in writing.
Sponsors of events are not permitted to: (i) make investment recommendations or provide investment advice to attendees of the event; (ii) engage in any investment negotiations between the company and investors attending the event; (iii) charge attendees fees beyond a reasonable administrative fee; (iv) receive compensation for making introductions; or (v) receive any compensation with respect to the event that would require registration as a broker-dealer or investment advisor.
Advertising for the event is also limited and may not reference any specific offering of securities by a participating company. To address concerns that communications for demo day events will encompass a large number of non-accredited investors especially in light of the increase in virtual events, the new rule limits online participation for an event to: (i) individuals who are members of, or otherwise associated with the sponsor organization; (b) individuals that the sponsor reasonably believes are accredited investors; or (iii) individuals who have been invited to the event by the sponsor based on industry or investment related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event.
Rule 148 also regulates the information a presenting company can convey to: (i) notification that the company is in the process of an offering or planning an offering of securities; (ii) the type and amount of securities being offered; (iii) use of proceeds; and (iv) the remaining unsubscribed amount of an offering.
Rule 148 is a non-exclusive method of communicating with potential investors. Companies may continue to rely on previously issued guidance to attend events where the participation is limited to individuals or groups of individuals with whom the company or the organizer has a pre-existing substantive relationship or that have been contacted through an informal, personal network of experienced, financially sophisticated individuals. In those events, the information provided by the company is not limited.
Solicitations of Interest; New Rule 241
Prior to the JOBS Act, almost no exempt offerings (except intrastate offerings when allowed by the state) allowed for advertising or soliciting, including solicitations of interest or testing the waters. The JOBS Act created the current Regulation A, which allows for testing the waters subject to certain SEC filing requirements and the inclusion of specific legends on the offering materials. For a discussion on Regulation A test-the-waters provisions, see HERE.
The SEC recognizes the benefits of testing the waters prior to incurring the costs associated with an offering. As such, the SEC is adopting new Rule 241, which exempts companies from the registration requirements for generic pre-offering communications that are made in compliance with the rule. Rule 241 allows companies to solicit indications of interest in an exempt offering, either orally or in writing, prior to determining which exemption they will rely upon, even if the ultimate exemption does not allow for general solicitation or advertising. Rule 241 is an exemption from the registration requirements for “offers” but not “sales,” but since communications under the rule are considered “offers,” they are subject to the antifraud provisions under the federal securities laws.
Rule 241 is similar to existing Rule 255 of Regulation A. Rule 241 communications require a legend or disclaimer stating that: (i) the company is considering an exempt offering but has not determined the specific exemption it will rely on; (ii) no money or other consideration is being solicited, and if sent, will not be accepted; (iii) no sales will be made or commitments to purchase accepted until the company determines the exemption to be relied upon and where the exemption includes filing, disclosure, or qualification requirements, all such requirements are met; and (iv) a prospective purchaser’s indication of interest is non-binding.
Once a company determines which type of offering it intends to pursue, it would no longer be able to rely on Rule 241 but would need to comply with the rules associated with that particular offering type, including its solicitation of interest and advertising rules. Moreover, since the solicitation of interest would likely be a general solicitation, if the chosen offering does not allow general solicitation or advertising, the company would need to conduct an integration analysis to make sure that there would be no integration between the solicitation of interest and the offering. Under the new rules, that would generally require the company to wait 30 days between the solicitation of interest and the offering (see Part 1 of this blog series HERE). I say “would likely be a general solicitation” because a company may still indicate interest from persons that it has a prior business relationship with, without triggering a general solicitation, as they can now under the current rules.
If a company elects to proceed with a Regulation A or Regulation Crowdfunding offering, it will need to file the Rule 241 test-the-waters materials if the Rule 241 solicitation is within 30 days of the ultimate offering, as such solicitation of interest would integrate with the following offering. If more than 30 days pass, the Rule 241 communications would not need to be filed, but any Rule 255 communication would need to be filed in a Regulation A offering and new Rule 206 communications would need to be filed in a Regulation Crowdfunding offering.
Although new Rule 241 does not limit the type of investor that can be solicited (accredited or non-accredited), under the new rules, if a company determines to proceed with a Rule 506(b) offering within 30 days of obtaining indications of interest, it must provide the non-accredited investors, if any, with a copy of any written solicitation of interest materials that were used.
New Rule 241 does not pre-empt state securities laws. Accordingly, if a company ultimately proceeds with an offering that does not pre-empt state law, it will need to consider whether it has met the state law requirements, including whether each state allows for solicitations of interest prior to an offering. This provision will likely be a large impediment to a company that is considering an offering that does not pre-empt state law.
Regulation Crowdfunding; New Rule 206; Amended Rule 204
Prior to the amendments, a company could not solicit potential investors until their Form C is filed with the SEC. New Rule 206 will allow both oral and written test-the-waters communications prior to the filing of a Form C much the same as Regulation A. Under Rule 206, companies are permitted to test the waters with all potential investors.
The testing-the-waters materials will be considered offers that are subject to the antifraud provisions of the federal securities laws. Like Regulation A, any test-the-waters communications will need to contain a legend including: (i) no money or other consideration is being solicited, and if sent, will not be accepted; (ii) no sales will be made or commitments to purchase accepted until the Form C is filed with the SEC and only through an intermediary’s platform; and (iii) a prospective purchaser’s indication of interest is non-binding. Any test-the-waters materials will need to be filed with the SEC as an exhibit to the Form C.
Unlike Regulation A, Rule 206 only allows for testing the waters prior to the filing of a Form C with the SEC. Once the Form C is filed, any offering communications are required to comply with the terms of Regulation Crowdfunding, including the Rule 204 advertising restrictions.
However, the SEC has also amended Rule 204 to permit oral communications with prospective investors once the Form C is filed. The SEC has also expanded upon the allowed categories of advertised information that can be provided under Rule 204. Rule 204 generally allows a company to advertise a Regulation Crowdfunding offering by directing potential investors to the intermediary’s platform. Rule 204 allows such advertisements to include limited information about the offering. The SEC has added: (i) a brief description of the planned use of proceeds of the offering; and (ii) information on the company’s progress towards meeting its funding goals, to the already allowable: (a) statement that the company is conducting an offering under Regulation Crowdfunding; (b) the name of the intermediary and a link to the intermediary’s platform; (c) the terms of the offering; and (d) factual information about the legal identity and business location of the company including its full name, address, phone number, web site address, email of a representative and a brief description of the business.
The SEC has further amended Rule 204 to specify that a company may provide information about the terms of an offering under Regulation Crowdfunding in the offering materials for a concurrent offering, such as in an offering statement on Form 1-A for a concurrent Regulation A offering or a Securities Act registration statement filed with the SEC, without violating Rule 204. To do so, the information provided about the Regulation Crowdfunding offering must be in compliance with Rule 204, including the requirement to include a link directing the potential investor to the intermediary’s platform. However, since SEC rules prohibit live links to locations outside the EDGAR system, the link in such a filing could not be a live hyperlink.
Further Background Reading
Prior to the rule changes, the SEC issued a concept release and request for public comment on the subject in June 2019 (see HERE). Also, for my five-part blog series on the proposed rules, see HERE, HERE , HERE, HERE, and HERE.